Description

We see ARRY as a very compelling short with both near-term catalysts and long-term headwinds.  With expectations running very high, it is positioned to disappoint.  We think an interesting pair trade is long FLEX (which we wrote up here) and short ARRY.  FLEX for reference owns the #1 solar tracker company internationally and has discussed the possibility of spinning it out.  Applying ARRY’s current multiple to our Nextracker estimates and a conservative 11x on the rest of the business would yield a $39 target price, 113% upside from today’s price of $18.25.  The main points of the ARRY thesis are:

1.       2021 Disappointment / ITC Risk: we see downside risk to 2021 numbers, especially around bookings and backlog, which is what drives the stock.  In 2020, the Investment Tax Credit (ITC) for solar stepped down to 26% from 30%, ahead of this customers purchased a significant amount of inventory to safe harbor to qualify for the tax break.  With the ITC, customers can incur 5% of the total project cost in the year but don’t have to finish the project for four years (eg to qualify for 2019, they can purchase in 2019 but not finish the project until 2023).  The higher-cost part of trackers are good candidates for the ITC as their price is much more stable than solar modules.  For example, ARRY booked about ~4GW of safe harbor bookings in 4Q19, which compares to 8/9GW of total shipments for 2020.  Checks indicate most of this inventory is sitting in warehouses.  The ITC was scheduled to step-down to 22% at the end of this year, but under the latest stimulus bill, this has been extended to the end of 2022.  Consequently, customers will be more compelled to deplete this inventory vs buy ahead of the next step-down as they now have two years until that happens. As a result, with over 90% of revenue in the US, we see significant risk to ARRY’s expectations next year.  Wood Mackenzie, a trusted industry data provider and consultant, estimates the US market down next year.  Notably, this was before the ITC extension, which could create more of a pocket in demand in ’21 and ’22.  This compares to expectations of ARRY’s US revenue up low teens in ’21 and ’22.

2.       Gross Margins Unsustainable: we believe that the revenue that ARRY shipped related to the ITC was higher-value and margin as customers prefer to safe harbor higher-cost dynamic parts instead of taking up warehouse space with big low priced static parts like steel.  Consequently, as the ITC inventory of higher-value dynamic parts are put into work over the coming years, we believe more of ARRY’s sales will shift towards the lower-margin static parts like steel to complete the product.  Additionally, if ARRY were to successfully expand internationally as outlined in the bull case, which we have hesitations on as outlined below, margins will compress based on our checks and as can be seen with international competitors such as Soltec with margins in the single-digits. 

3.       International Expansion: ARRY currently has very little international revenue of $65mm estimated for 2020.  A big driver of the ARRY bull case is an expectation of significant international expansion, the street is forecasting international revenue growth of 4-6x by 2023.  We believe this will disappoint.  Unlike the US, where ARRY and Nextracker dominate, there are more local competitors internationally, such as Soltec in Spain who recently IPO’d and has well-regarded technology, and Archtech out of China.  Additionally, Nextracker is very strong internationally with a presence in over 30 countries vs ARRY at 2 (US and Australia) and we conservatively estimate over 10x the international revenues with $600mm+.  To compete internationally, you need a robust international supply chain, along with local providers.  Nextracker has built out their international footprint over the years and leverages FLEX’s supply chain expertise.  To grow internationally, ARRY will have to build-out a supply chain and hire people locally (eg LatAm where there is limited evidence of traction or hiring), both of which will take time hindering growth as their peers get stronger.  Additionally, for the big international utilities it can take years to qualify suppliers.  Furthermore, ARRY discusses lower Operating & Maintenance (O&M) as a competitive advantage as they use one motor for 32 rows of solar panels vs their competitors (eg Nextracker, Soltec, Archtech etc) using a motor for each row (more on this below), so less parts and maintenance.  However, checks indicate that internationally the vast majority of O&M is labor, which diminishes ARRY’s lower O&M benefit given many regions of solar growth will come from areas of low labor costs.  We also believe when Oaktree acquired ARRY in July 2016 they underwrote international expansion as part of the thesis, but have been unable to achieve this over their four years of ownership. 

4.       Technology Disadvantage: importantly, we believe ARRY’s one motor per 32 rows of solar panels product is disadvantaged going forward.  As ARRY’s trackers cannot move each individual row, there is less flexibility to optimize each row’s panels based on sun position, weather conditions, and shading from other panels (which becomes important with bi-facial modules, which is where the industry is migrating to).  Additionally, software across the industry is improving and benefiting the ROI of trackers.  Individual row trackers can leverage the software better given the enhanced flexibility.  Additionally, single-row trackers work better on non-flat terrain.  As solar continues to grow, the terrain will become more complex providing an advantage for single-row trackers.

5.       Significant Founder and Sponsor Selling and Pending Secondary: Since ARRY’s IPO in October, both Oaktree and the ARRY founder, Ron Corio, have sold around 2/3 of their stakes.  With the stock significantly up since the last secondary, we expect more selling when the next lock-up ends on February 28th.  Oaktree and Corrio still own 28% of the shares outstanding, we believe this could weigh heavily on the stock.

6.       Nextracker Spin: as discussed on their latest earnings call, FLEX is evaluating options to best realize the value of Nextracker.  Our research shows that Nextracker operates relatively independently within FLEX and there is nothing structural that would prevent them from spinning it out.  We expect a spin to come at any moment.  We believe this will be a negative catalyst for ARRY as it will a) highlight the competitive disadvantages of ARRY vs Nextracker and their #1 share globally. While decreasing the public market scarcity value of ARRY.  In the comments section of our FLEX pitch, we have linked to a podcast episode with Nextracker’s CEO from last week that we recommend listening to.  Among several takeaways, the CEO commented on SPACs, which we believe could be an avenue of value realization for FLEX.

7.       Valuation: even in a bull scenario where ARRY grows US revenue at a 20% CAGR from 2019-2030 (which would keep market share stable assuming 20% market growth, though 20% may prove elevated as, similar to 2020, 2019 also had some inventory build related to the ITC) and captures 33% of the international market by 2030 (assuming 20% international market growth), with margins down-ticking only 1% to 14.5% despite what we believe to be inflated margins from the ITC dynamic discussed in point #2 and lower-margin internationally growing to 46% of the revenue mix, would yield a $46 target price, just 3% upside, using an 8% cost of capital and 22.5x terminal unlevered cash flow multiple.  We think in a more realistic scenario of US MW 2019-2030 CAGR of 17.5% from and stable US market share, international market share growing to 10% off 17.5% industry growth and ~2% margin degradation (~13.5% operating margin, which would still be a premium vs peers), 8% cost of capital and a 20x terminal multiple yields a $22 share price for 52% downside.  Based on our diligence, we also see a decent chance of a bear case where margins are much worse and the company loses share.  We feel that the probability of this bear case is higher than the bull scenario.

Given the retail and ESG interest in solar, solar shorts can be challenging.  A solar ETF can be used to hedge against this but we believe a FLEX pair trade more interesting.  In addition to Nextracker, FLEX has other solar exposure such as being the primary supplier to ENPH, which could be over 3% of sales.

Catalyst

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